SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

ý  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended         June 30, 2004

 

o  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission File No. 0-31525

 

COMMUNITY VALLEY BANCORP

(Exact name of registrant as specified in its charter)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

Yes  ý     No  o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12-b-2)

 

Yes  o     No  ý

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

 

No par value Common Stock – 3,635,956 shares outstanding at July 31, 2003.

 

 

PART 1-FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

 

COMMUNITY VALLEY BANCORP

CONSOLIDATED BALANCE SHEET (Unaudited)

 

(In thousands except per share data)		June 30, 2004			December 31, 2003
ASSETS
Cash and due from banks		$	27,698		$	26,205
Federal funds sold		43,110			50,605
Interest-bearing deposits in banks		9,013			7,925
Investment securities (market value of $4,428 at June 30, 2004 and $4,326 at December 31, 2003)		4,471			4,325
Loans held for sale		1,445			2,279
Loans, less allowance for loan losses of $4,013 at June 30, 2004 and $3,587 at December 31, 2003		304,129			270,231
Bank premises and equipment, net		9,065			8,554
Accrued interest receivable and other assets		15,655			16,599
		$	414,586		$	386,723
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Non-interest bearing		$	78,511		$	68,463
Interest bearing		289,121			274,048
Total deposits		367,632			342,511
Employee stock ownership plan note payable		759			832
Subordinated debenture		8,248			8,248
Accrued interest payable and other liabilities		5,832			5,183
Total liabilities		382,471			356,774
Commitments and contingencies
Shareholders’ equity:
Common stock – no par value; 20,000,000 shares authorized; issued and outstanding – 3,635,956 shares at June 30, 2004 and 3,621,824 shares at December 31, 2003		7,695			7,271
Unearned ESOP shares (87,412 shares at June 30, 2004 and 90,909 shares at December 31, 2003, at cost)		(1,033		)	(1,070		)
Retained earnings		25,453			23,746
Accumulated other comprehensive income, net (Note 3)		0			2
Total shareholders’ equity		32,115			29,949
		$	414,586		$	386,723

 

See Notes to Unaudited Consolidated Financial Statements

 

2

 

COMMUNITY VALLEY BANCORP

CONSOLIDATED STATEMENT OF INCOME

(Unaudited)

 

		For the periods ended June 30,
		Three months						Six Months
(In thousands, except per share data)		2004			2003			2004			2003
Interest income:
Interest and fees on loans		$	5,615		$	4,871		$	10,972		$	9,645
Interest on Federal funds sold		121			199			243			381
Interest on deposits in banks		58			49			116			90
Interest and dividends on investment securities:
Taxable		33			26			61			62
Exempt from Federal income taxes		10			19			20			38
Dividends		3						3
Total interest income		5,840			5,164			11,415			10,216
Interest expense:
Interest on deposits		849			1,019			1,727			2,032
Interest on subordinated debt		102			104			203			234
Interest on note payable		8			8			17			16
Total interest expense		959			1,131			1,947			2,282
Net interest income		4,881			4,033			9,468			7,934
Provision for loan losses		190			120			415			270
Net interest income after provision for loan losses		4,691			3,913			9,053			7,664
Non-interest income		1,554			1,383			2,783			2,566
Non-interest expense:
Salaries and employee benefits		2,101			1,945			4,380			3,886
Occupancy		245			204			484			376
Furniture and equipment		311			233			664			473
Other expense		1,092			950			2,008			1,816
Total non-interest expense		3,749			3,332			7,536			6,551
Income before income taxes		2,496			1,964			4,300			3,679
Income taxes		1,031			848			1,747			1,526
Net income		$	1,465		$	1,116		$	2,553		$	2,153
Basic earnings per share (Note 2)		$	.41		$	.32		$	.72		$	.61
Diluted earnings per share (Note 2)		$	.39		$	.30		$	.68		$	.58
Cash dividends per share of issued and outstanding common stock		$	.075		$	.056		$	.15		$	.11

 

See Notes to Unaudited Consolidated Financial Statements

 

3

 

COMMUNITY VALLEY BANCORP

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

(Unaudited)

(In thousands except number of shares)

 

													Accumulated
							Unearned						Other			Total
		Common Stock					ESOP			Retained			Comprehensive			Shareholders’			Comprehensive
		Shares		Amount			Shares			Earnings			Income			Equity			Income
Balance, January 1, 2003		3,580,468		$	6,660		$	(852	)	$	19,559		$	14		$	25,381
Comprehensive income (Note 3):
Net income										5,269						5,269			$	5,269
Other comprehensive loss, net of tax
Unrealized loss on available-for-sale investment securities													(12		)	(12		)	(12		)
																			$	5,257
Exercise of stock options and related tax benefit		41,356		462												462
Earned ESOP shares				150			102									252
Shares acquired or redeemed by ESOP							(321		)							(321		)
Cash dividends- $.30 per share										(1,082		)				(1,082		)
Balance, December 31, 2003		3,621,824		7,272			(1,071		)	23,746			2			29,949
Comprehensive income (Note 3):
Net income										2,553						2,553			$	2,553
Other comprehensive loss, net of tax:
Unrealized loss on available-for-sale investment securities													(2		)	(2		)	(2		)
Total comprehensive income																			$	2,551
Retirement of common stock		(12,000	)	(25		)				(299		)				(324		)
Exercise of stock options and related tax benefit		26,132		397												397
Earned ESOP shares				51			38									89
Cash dividends declared										(547		)				(547		)
Balance, June 30, 2004		3,635,956		$	7,695		$	(1,033	)	$	25,453		$	0		$	32,115

 

See Notes to Unaudited Consolidated Financial Statements

 

4

 

COMMUNITY VALLEY BANCORP

CONSOLIDATED STATEMENT OF CASH FLOWS  (Unaudited)

 

(In thousands) For the six months ended June 30,		2004			2003
Cash flows from operating activities:
Net income		$	2,553		$	2,153
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		415			270
Deferred loan origination costs, net		23			(50		)
Depreciation and amortization		646			497
Gain on disposition of Bank premises and equipment					(1		)
Net decrease in loans held for sale		834			3,301
Increase in cash surrender value of bank-owned life insurance		(250		)	(1,705		)
Non-cash compensation expense associated with the ESOP		90			83
Decrease in accrued interest receivable and other assets		1,387			367
Increase (decrease) in accrued interest payable and other liabilities		647			(1,017		)
Net cash provided by operating activities		6,345			3,898
Cash flows from investing activities:
Increase in interest-bearing deposits in banks		(1,088		)	(2,577		)
Proceeds from called available-for-sale investment securities		300
Proceeds from called held-to-maturity investment securities		250			2,200
Proceeds from matured held-to-maturity investment securities		130
Proceeds from principal payments of held-to-maturity investment securities		150
Purchase of held-to-maturity investment securities		(1,012		)	(1,311		)
Purchases of bank premises and equipment		(1,448		)	(748		)
Proceeds from sale of bank premises and equipment		323
Net increase in loans		(34,336		)	(12,237		)
Net cash used in investing activities		(36,731		)	(14,641		)
Cash flows from financing activities:
Net increase in demand, interest-bearing and savings deposits		$	22,737		$	27,720
Net increase (decrease) in time deposits		2,384			(3,312		)
Repayment of ESOP loan, net		(73		)	10
Payment of cash dividends		(544		)	(538		)
Cash paid for fractional shares		(6		)
Exercise of stock options		210			151
Purchase of unearned ESOP shares					(78		)
Common shares purchased		(324		)
Net cash provided by financing activities		24,384			30,577
(Decrease) increase in cash and cash equivalents		(6,002		)	19,834
Cash and cash equivalents at beginning of year		76,810			73,031
Cash and cash equivalents at end of period		$	70,808		$	92,865

 

See Notes to Unaudited Consolidated Financial Statements

 

5

 

Community Valley Bancorp and Subsidiaries

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

1.   BASIS OF PRESENTATION

 

The accompanying unaudited consolidated financial statements of Community Valley Bancorp and subsidiaries (the “Company”) have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, certain information and notes required by accounting principles generally accepted in the United States for annual financial statements are not included herein.  In the opinion of management, all adjustments (which consist solely of normal recurring accruals) considered necessary for a fair presentation of the results for the interim periods presented have been included.  These interim consolidated financial statements should be read in conjunction with the financial statements and related notes contained in the Company’s 2003 Annual Report to Shareholders on Form 10-K.

 

The consolidated financial statements include the accounts of the Company and its wholly owned bank subsidiary, Butte Community Bank.  All significant inter-company balances and transactions have been eliminated in consolidation.  The results of operations for the three and six month periods ended June 30, 2004 may not necessarily be indicative of the operating results for the full year 2004.

 

On February 20, 2004, the Board of Directors declared a four-for-three stock split effective March 26, 2004 for shareholders of record on March 2, 2004.  All share and per share data has been retroactively adjusted to reflect the stock split.

 

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions.  These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from these estimates.

 

2.  EARNINGS PER SHARE COMPUTATION

 

Basic earnings per share are computed by dividing net income by the weighted average common shares outstanding for the period (3,555,791 and 3,548,252 shares for the three and six month periods ended June 30, 2004 and 3,504,448 and 3,502,404 shares for the three and six month periods ended June 30, 2003).  Diluted earnings per share reflect the potential dilution that could occur if outstanding stock options were exercised using the treasury stock method.   Diluted earnings per share is computed by dividing net income by the weighted average common shares outstanding for the period plus the dilutive effect of options (242,179 and 256,593 shares for the three and six month periods ended June 30, 2004 and 195,220 and 186,395 shares for the three and six month periods ended June 30, 2003).  Earnings per share are retroactively adjusted for stock splits and dividends for all periods presented.

 

3. COMPREHENSIVE INCOME

 

Comprehensive income is reported in addition to net income for all periods presented.  Comprehensive income is made up of net income plus other comprehensive income or loss.  The Company’s only source of comprehensive income or loss, is comprised of changes in unrealized gains or losses, net of taxes, on available-for-sale securities, adjusted for the effect of realized gains or losses on available-for-sale securities, net of taxes.

 

6

 

4.  STOCK –BASED COMPENSATION

 

The Company issues stock options under three stock-based compensation plans, the Community Valley Bancorp 1991, 1997 and 2000 Stock Option Plans.  The Company accounts for these plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations.  No stock-based compensation cost is reflected in net income, as all options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant.  In accordance with Financial Accounting Standards Board (“FASB”) No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, an Amendment of FASB No. 123, the following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.

 

Pro forma adjustments to the Company’s consolidated net earnings and earnings per share are disclosed during the periods in which the options become vested.

 

(In thousands, except per share data)

 

		Three Months Ended
		June 30, 2004			June 30, 2003
Net income as reported		$	1,465		$	1,116
Deduct:  Total stock-based compensation expense determined under the fair value based method for all awards, net of related tax effects		(71		)	(64		)
Pro forma net income		$	1,394		$	1,052
Basic earnings per share - as reported		$	0.41		$	0.32
Basic earnings per share - pro forma		$	0.39		$	0.30
Diluted earnings per share - as reported		$	0.39		$	0.30
Diluted earnings per share - pro forma		$	0.37		$	0.28

 

7

 

		Six Months Ended
		June 30, 2004			June 30, 2003
Net earnings as reported		$	2,553		$	2,153
Deduct:  Total stock-based compensation expense determined under the fair value based method for all awards, net of related tax effects		(143		)	(129		)
Pro forma net income		$	2,410		$	2,024
Basic earnings per share - as reported		$	0.72		$	0.61
Basic earnings per share - pro forma		$	0.68		$	0.58
Diluted earnings per share - as reported		$	0.68		$	0.58
Diluted earnings per share - pro forma		$	0.63		$	0.56

 

8

 

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF COMMUNITY VALLEY BANCORP

 

The following is Community Valley Bancorp’s (the “Company”) management’s discussion and analysis of the significant changes in balance sheet accounts for June 30, 2004 and December 31, 2003 and income and expense accounts for the three and six month periods ended June 30, 2004 and 2003. The discussion is designed to provide a better understanding of significant trends related to the Company’s financial condition, results of operations, liquidity, capital resources and interest rate sensitivity.

 

In addition to the historical information contained herein, this report on Form 10-Q contains certain forward-looking statements.  The reader of this report should understand that all such forward-looking statements are subject to various uncertainties and risks that could affect their outcome.   The Company’s actual results could differ materially from those suggested by such forward-looking statements.  Factors that could cause or contribute to such differences include, but are not limited to, variances in the actual versus projected growth in assets, return on assets, loan losses, expenses, rates charged on loans and earned on securities investments, rates paid on deposits, competition effects, fee and other noninterest income earned, general economic conditions, nationally, regionally and in the operating market areas of the Company and its subsidiaries, changes in the regulatory environment, changes in business conditions and inflation, changes in securities markets, data processing problems, a decline in real estate values in the Company’s market area,  the effects of terrorism, including the events of September 11, 2001 and thereafter, and the conduct of the war on terrorism by the United States and its allies, as well as other factors. This entire report should be read putting such forward-looking statements in context.

 

General Development of Business

 

The Company is a bank holding company registered under the Bank Holding Company Act of 1956, as amended. The Company was incorporated under the laws of the State of California in 2002.  As a bank holding company, the Company is authorized to engage in the activities permitted under the Bank Holding Company Act of 1956, as amended, and regulations thereunder.  Its principal office is located at 2041 Forest Avenue, Chico, California 95928 and its telephone number is (530) 899-2344.

 

The Company owns 100% of the issued and outstanding common shares of Butte Community Bank.  Butte Community Bank was incorporated and commenced business in Paradise and Oroville, California in 1990.  Butte Community Bank operates ten full service offices within its primary service areas of Butte, Sutter, Yuba and Tehama Counties.  The Bank also maintains Loan Production Offices in Citrus Heights and Redding. Butte Community Bank’s primary business is serving the commercial banking needs of small to mid-sized businesses and consumers within those counties.  Butte Community Bank accepts checking and savings deposits, offers money market deposit accounts and certificates of deposit, makes secured and unsecured commercial, secured real estate, and other installment and term loans and offers other customary banking services.

 

Critical Accounting Policies

 

General

 

The Company’s significant accounting principles are described in Note 2 of the consolidated financial statements and are essential to understanding Management’s Discussion and Analysis of Results of Operations and Financial Condition. Community Valley Bancorp’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. Some of the Company’s accounting principles require significant judgement to estimate values of assets or liabilities. In addition, certain accounting principles require significant judgment in applying the complex accounting principles to transactions to determine the most appropriate treatment. The following is a summary of the more judgmental and complex accounting estimates and principles.

 

9

 

Allowance for Loan Losses (ALL)

 

The allowance for loan losses is management’s best estimate of the probable losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting:  (1) SFAS No.5 which requires that losses be accrued when they are probable of occurring and estimable and (2) SFAS No. 114, which requires that losses be accrued on impaired loans based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The Company performs periodic and systematic detailed evaluations of its lending portfolio to identify and estimate the inherent risks and assess the overall collectibility. These evaluations include general conditions such as the portfolio composition, size and maturities of various segmented portions of the portfolio such as secured, unsecured, construction, and Small Business Administration (“SBA”).

 

Additional factors include concentrations of borrowers, industries, geographical sectors, loan product, loan classes and collateral types, volume and trends of loan delinquencies and non-accrual, criticized and classified assets and trends in the aggregate in significant credits identified as watch list items. There are several components to the determination of the adequacy of the ALL. Each of these components is determined based upon estimates that can and do change when the actual events occur. The Company estimates the SFAS No. 5 portion of the ALL based on the segmentation of its portfolio. For those segments that require an ALL, the Company estimates loan losses on a monthly basis based upon its ongoing loan review process and analysis of loan performance. The Company follows a systematic and consistently applied approach to select the most appropriate loss measurement methods and support its conclusions and rationale with written documentation. One method of estimating loan losses for groups of loans is through the application of loss rates to the groups’ aggregate loan balances. Such rates typically reflect historical loss experience for each group of loans, adjusted for relevant economic factors over a defined period of time. The Company evaluates and modifies its loss estimation model as needed to ensure that the resulting loss estimate is consistent with GAAP.

 

For individually impaired loans, SFAS No. 114 provides guidance on the acceptable methods to measure impairment. Specifically, SFAS No. 114 states that when a loan is impaired, the Company should measure impairment based on the present value of expected future principal and interest cash flows discounted at the loan’s effective interest rate, except that as a practical expedient, a creditor may measure impairment based on a loan’s observable market price or the fair value of collateral, if the loan is collateral dependent. When developing the estimate of future cash flows for a loan, the Company considers all available information reflecting past events and current conditions, including the effect of existing environmental factors.

 

Loan Sales and Servicing

 

The Company originates government guaranteed loans and mortgage loans that may be sold in the secondary market.  The amounts of gains recorded on sales of loans and the initial recording of servicing assets and interest only (I/O) strips is based on the estimated fair values of the respective components.  In recording the initial value of the servicing assets and the fiar value of the I/O strips receivable, the Company uses estimates which are made based on management’s expectations of future prepayment and discount rates.  Servicing assets are amortized over the estimated life of the related loan.  I/O strips are not significant at December 31, 2003.  These prepayment and discount rates were based on current market conditions and historical performance of the various pools of serviced loans.  If actual prepayments with respect to sold loans occur more quickly than projected the carrying value of the servicing assets may have to be adjusted through a charge to earnings.

 

Stock-Based Compensation

 

The Company uses the intrinsic value based method for measuring compensation cost related to stock options. Under the intrinsic value based method, compensation cost is the excess, if any, of the quoted market price of the stock at grant date over the amount an employee must pay to acquire the stock. This cost is amortized on a straight-line basis over the vesting period of the options granted. The Company applies Accounting Principles Board Opinion (“APB”) No. 25 Accounting for Stock Issued to Employees and related interpretations in accounting for stock options.  No compensation cost has been recorded in the accompanying financial statements because all options have been granted at an exercise price of no less than the fair market value at date of grant.

 

10

 

Revenue recognition

 

The Company’s primary source of revenue is interest income, which is the difference between the interest income it receives on interest-earning assets and the interest expense it pays on interest-bearing liabilities, and (ii) fee income, which includes fees earned on deposit services, income from SBA lending, electronic-based cash management services, mortgage brokerage fee income and merchant credit card processing services. Interest income is recorded on an accrual basis. Note 1 to the Consolidated Financial Statements offers an explanation of the process for determining when the accrual of interest income is discontinued on an impaired loan.

 

Income Taxes

 

The Company accounts for income taxes under the asset and liability method. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using currently enacted tax rates applied to such taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. If future income should prove non-existent or less than the amount of deferred tax assets within the tax years to which they may be applied, the asset may not be realized and our net income will be reduced.

 

Overview

 

The Company recorded net income of $1,465,000 for the quarter ended June 30, 2004, which was a 31% increase from the $1,116,000 reported for the same period of 2003.  Diluted earnings per share for the second quarter of 2004 were $0.39, compared to the $0.30 recorded in the second quarter of 2003.  The annualized return on average equity (ROAE) and the return on average assets (ROA) for the second quarter of 2004 were 18.45% and 1.43%, respectively, as compared to 16.62% and 1.25%, respectively, for the same period in 2003.

 

Net income for the six months ended June 30, 2004 was $2,553,000 (up 18.6%) compared to the $2,153,000 recorded in the first six months of 2003.   The primary reason for the increase in net income was the growth in earning assets the company experienced.

 

Total assets of the Company increased by $28,700,000 or (7.2%) from December 31, 2003 to $414,500,000 at June 30, 2004.  Net loans totaled $304,100,000, up $33,900,000 (12.5%) from the ending balances on December 31, 2003.  Deposit balances at June 30, 2004 totaled $367,600,000, up $25,100,000 (7.3%) from December 31, 2003.

 

Table One below provides a summary of the components of net income for the periods indicated:

 

11

 

Table One:  Components of Net Income

 

		Three months ended June 30,						Six months ended June 30,
(In thousands, except percentages)		2004			2003			2004			2003
Net interest income		$	4,881		$	4,033		$	9,468		$	7,934
Provision for loan losses		(190		)	(120		)	(415		)	(270		)
Non-interest income		1,554			1,383			2,783			2,566
Non-interest expense		(3,749		)	(3,332		)	(7,536		)	(6,551		)
Provision for income taxes		(1,031		)	(848		)	(1,747		)	(1,526		)
Net income		$	1,465		$	1,116		$	2,553		$	2,153
Average total assets (In millions)		$	413.0		$	360.8		$	401.6		$	346.3
Net income (annualized) as a percentage of average total assets		1.42		%	1.24		%	1.27		%	1.24		%

 

Results of Operations

 

Net Interest Income and Net Interest Margin

 

Net interest income represents the excess of interest and fees earned on interest earning assets (loans, securities, federal funds sold and investments in time deposits) over the interest paid on deposits and borrowed funds.  Net interest margin is net interest income expressed as a percentage of average earning assets.

 

The Company’s net interest margin was 5.42% for the three month and six month periods ending June 30, 2004.  Net interest income increased $848,000 (21%) for the second quarter of 2004 compared to the same period in 2003.  Net interest income increased $1,534,000 (19.3%) for the six months ended June 30, 2004 over the same period in 2003.   The primary reason for this increase was the loan growth and the resulting interest income and fees associated with that growth together with the decrease in the interest rates paid on deposits.

 

Interest expense was $172,000 (15.2%) lower in the second quarter of 2004 versus the prior year period. The average balances of interest bearing liabilities were $33,264,000 (12.6%) higher in the second quarter of 2004 versus the same quarter in 2003. Even though the interest bearing balances increased, rates paid on these liabilities decreased 42 basis points on a quarter over quarter basis.     Interest expense was $335,000 (14.6%) lower in the six month period ended June 30, 2004 versus the prior year period.  The average balances of interest bearing liabilities were $34,342,000 (13.4%) higher in the six-month period ended June 30, 2004 versus the same period in 2003.  Rates paid on interest bearing liabilities decreased 45 basis points on a year over year basis.  The reason for this decrease was the ability of management to channel the growth of the deposits away from higher interest rate certificates of deposit to lower rate demand deposits and to lower the average cost of certificates of deposit as higher cost deposits were re-priced in a lower rate environment.

 

Table Two, Analysis of Net Interest Margin on Earning Assets, and Table Three, Analysis of Volume and Rate Changes on Net Interest Income and Expenses, are provided to enable the reader to understand the components and past trends of the Company’s interest income and expense.  Table Two provides an analysis of net interest margin on earning assets setting forth average assets, liabilities and shareholders’ equity; interest income earned and interest expense paid and average rates earned and paid; and the net interest margin on earning assets.

 

12

 

Table Two:  Analysis of Net Interest Margin on Earning Assets

 

Three Months Ended June 30,

 

		2004								2003
(In thousands, except percentages)		Avg Balance			Interest			Avg Yield (4)		Avg Balance			Interest			Avg Yield (4)
Assets:
Earning assets
Loans (1)		$	298,616		$	5,615		7.56	%	$	246,939		$	4,871		7.91	%
Taxable investment securities		3,897			36			3.41	%	1,812			26			5.76	%
Tax-exempt investment securities (2)		705			10			5.71	%	975			19			7.82	%
Federal funds sold		49,979			121			0.97	%	67,480			199			1.18	%
Interest bearing deposits in banks		8,863			58			2.63	%	5,884			49			3.34	%
Total earning assets		362,060			5,840			6.49	%	323,090			5,164			6.41	%
Cash & due from banks		26,486								14,681
Other assets		24,489								23,112
		$	413,036							$	360,884
Liabilities & Shareholders’ Equity
Interest bearing liabilities:
NOW & MMDA		$	174,829		263			0.61	%	$	145,708		370			1.03	%
Savings		27,993			34			0.49	%	21,678			26			.49	%
Time deposits		85,638			552			2.59	%	87,836			623			2.88	%
Other borrowings		8,782			110			5.04	%	8,756			112			5.19	%
Total interest bearing liabilities		297,242			959			1.30	%	263,978			1,131			1.72	%
Demand deposits		77,678								61,715
Other liabilities		6,174								8,265
Total liabilities		381,094								333,958
Shareholders’ equity		31,942								26,926
		$	413,036							$	360,884
Net interest income & margin (3)					$	4,881		5.42	%				$	4,033		5.00	%

 

(1)          Loan interest includes loan fees of $499,000 and $437,000 during the three months ended June 30, 2004 and June 30, 2003 respectively.

(2)          Does not include taxable-equivalent adjustments that primarily relate to income on certain securities that are exempt from federal income taxes.

(3)          Net interest margin is computed by dividing net interest income by total average earning assets.

(4)          Average yield is calculated based on actual days in quarter (91 for June 30, 2004 and June 30, 2003) and annualized to actual days in year (366 for 2004 and 365 for 2003).

 

13

 

Six Months Ended June 30,

 

		2004								2003
(In thousands, except percentages)		Avg Balance			Interest			Avg Yield (4)		Avg Balance			Interest			Avg Yield (4)
Assets:
Earning assets
Loans (1)		$	288,741		$	10,972		7.64	%	$	243,065		$	9,645		8.00	%
Taxable investment securities		3,619			61			3.39	%	2,041			62			6.03	%
Tax-exempt investment securities (2)		725			20			5.55	%	1,027			38			7.46	%
Federal funds sold		49,783			243			0.98	%	63,689			381			1.21	%
Interest bearing deposits in banks		8,555			116			2.73	%	5,284			90			3.43	%
Total earning assets		351,423			11,415			6.51	%	315,106			10,216			6.54	%
Cash & due from banks		25,979								14,297
Other assets		24,211								22,169
		$	401,613							$	351,572
Liabilities & Shareholders’ Equity
Interest bearing liabilities:
NOW & MMDA		$	170,603		564			.66	%	$	141,325		728			1.04	%
Savings		26,942			68			.51	%	21,108			63			.60	%
Time deposits		85,175			1,095			2.59	%	86,177			1,241			2.91	%
Other borrowings		9,037			220			4.90	%	8,745			250			5.76	%
Total interest bearing liabilities		291,757			1,947			1.34	%	257,355			2,282			1.79	%
Demand deposits		73,406								62,163
Other liabilities		5,074								5,561
Total liabilities		370,237								325,079
Shareholders’ equity		31,376								26,493
		$	401,613							$	351,572
Net interest income & margin (3)					9,468			5.42	%				7,934			5.08	%

 

(1)          Loan interest includes loan fees of $1,031,000 and $917,000 during the six months ended June 30, 2004 and June 30, 2003, respectively.

(2)          Does not include taxable-equivalent adjustments that primarily relate to income on certain securities that is exempt from federal income taxes.

(3)          Net interest margin is computed by dividing net interest income by total average earning assets.

(4)          Average yield is calculated based on actual days in period (182 for June 30, 2004 and 181 days for June 30, 2003) and annualized to actual days in year (366 for 2004 and 365 for 2003).

 

14

 

Table Three sets forth a summary of the changes in interest income and interest expense from changes in average asset and liability balances (volume) and changes in average interest rates.  On a quarter over quarter basis for the period ending June 30, 2004 net interest income has increased $848,000 over the same time period in 2003.  Interest income from earning assets has increased by $676,000. Changes in the volume of earning assets, primarily loans, have resulted in an increase in interest income of $1,014,000 while interest income from changes in rates has decreased by $338,000.  Interest expense for the second quarter of 2004 was $172,000 less than the same time period in 2003.  Changes in the volume of interest bearing liabilities, primarily the increase in balances of demand deposits, has resulted in a net increase of interest expense of $67,000.  Decreases in average rates paid, primarily on certificates of deposit and demand deposits have resulted in an interest expense reduction of $239,000.   On a year-to-date basis through June 30, 2004, net interest income has increased $1,535,000 over the same time period in 2003.  Interest income from earning assets has increased by $1,200,000.  Changes in the volume of earning assets, primarily loans, have resulted in an increase in interest income of $1,826,000 while interest income from changes in rates has decreased by $626,000.  Interest expense for the six month period was $335,000 less than the same time period in 2003.  Changes in the volume of interest bearing liabilities, primarily the increase in balances of demand deposits, have resulted in a net increase of interest expense of $163,000.  Decreases in average rates paid, primarily on certificates of deposit and demand deposits have resulted in an interest expense reduction of $498,000.

 

Table Three:  Analysis of Volume and Rate Changes on Net Interest Income and Expenses (Unaudited)

 

(In thousands) Three Months Ended June 30, 2004 over 2003

Increase (decrease) due to change in:

 

		Volume			Rate (3)			Net Change
Interest-earning assets:
Net loans (1)		$	1,017		$	(273	)	$	744
Taxable investment securities		30			(20		)	10
Tax exempt investment securities (2)		(5		)	(4		)	(9		)
Federal funds sold		(51		)	(27		)	(78		)
Investment in time deposits		25			(16		)	9
Total		1,014			(338		)	676
Interest-bearing liabilities:
Demand deposits		75			(182		)	(107		)
Savings deposits		8			8
Time deposits		(16		)	(55		)	(71		)
Other borrowings		0			(2		)	(2		)
Total		67			(239		)	(172		)
Interest differential		$	947		$	(99	)	$	848

 

(1)          The average balance of non-accruing loans is immaterial as a percentage of total loans and, as such, has been included in net loans.

(2)          Does not include taxable-equivalent adjustments that primarily relate to income on certain securities that is exempt from federal income taxes.

(3)          The rate/volume variance has been included in the rate variance.

 

15

 

Table Three:  Analysis of Volume and Rate Changes on Net Interest Income and Expenses (Unaudited)

 

(In thousands) Six Months Ended June 30, 2004 over 2003

Increase (decrease) due to change in:

 

		Volume			Rate (3)			Net Change
Interest-earning assets:
Net loans (1)		$	1,817		$	(490	)	$	1,327
Taxable investment securities		47			(44		)	3
Tax exempt investment securities (2)		(11		)	(7		)	(18		)
Federal funds sold		(83		)	(55		)	(138		)
Investment in time deposits		56			(30		)	26
Total		1,826			(626		)	1,200
Interest-bearing liabilities:
Demand deposits		151			(315		)	(164		)
Savings deposits		17			(12		)	5
Time deposits		(14		)	(133		)	(147		)
Other borrowings		9			(38		)	(29		)
Total		163			(498		)	(335		)
Interest differential		$	1,663		$	(128	)	$	1,535

 

(1)          The average balance of non-accruing loans is immaterial as a percentage of total loans and, as such, has been included in net loans.

(2)          Does not include taxable-equivalent adjustments that primarily relate to income on certain securities that is exempt from federal income taxes.

(3)          The rate/volume variance has been included in the rate variance.

 

16

 

Non-interest Income

 

Table Four below provides a summary of the components of noninterest income for the periods indicated (dollars in thousands) (percent of assets annualized):

 

Table Four:  Components of Noninterest Income (Unaudited)

 

Three Months Ended June 30,     

 

		2004			% of Avg. Assets		2003			% of Avg. Assets
Service charges on deposit accounts		$	511		.49		$	264		.28
Loan servicing fees		94			.09		374			.40
Fees - alternative investment sales		93			.09		61			.08
Merchant fee income		78			.08		45			.04
Gain on the sale of loans		543			.52		472			.52
Other		235			.23		167			.20
Total non-interest income		$	1,554		1.50		$	1,383		1.52

 

Six Months Ended June 30,     

 

		2004			% of Avg. Assets		2003			% of Avg. Assets
Service charges on deposit accounts		$	964		.48		$	522		.30
Loan servicing fees		186			.09		713			.41
Fees - alternative investment sales		230			.11		81			.05
Merchant fee income		162			.08		151			.09
Gain on the sale of loans		788			.39		766			.44
Other		453			.23		333			.19
Total non-interest income		$	2,783		1.38		$	2,566		1.48

 

Non-interest income was up $171,000 (12.4%) to $1,554,000 for the three months ended June 30, 2004 as compared to $1,383,000 for the three months ended June 30, 2003.    Increases in non-interest income were realized in fees from service charges (up 93.6%), fees from alternative investment sales (up 52.5%), merchant processing fees (up 73.3%), sale of loans (up 15%) and other (up 40.7%).

 

Loan servicing income declined as a result of fewer loans being sold on the secondary market through FNMA (Fannie Mae) as many customers of the Company had already taken advantage of the low levels in mortgage financing rates during 2003.

 

The increase in service charge income was the result of additional deposit accounts opened during the second quarter and fees resulting from the overdraft privilege deposit product.  The Investment Department, which sells third-party mutual funds and annuities, experienced an increase in fees due to an increase in sales during the second quarter.

 

For the six months ended June 30, 2004, non-interest income was up $217,000 (8.5%) to

 

17

 

$2,783,000 as compared to the $2,566,000 total for the six months ended June 30, 2003.   All of the components of non-interest income showed gains with the exception of loan servicing fees which was down $527,000 or (283%) for the same reason stated above for the three month period.  Increases were realized in service charges on deposit accounts (up 84.7%), alternative investment sales (up 184%), merchant fee income (up 7.3%), gain on sale of loans (up 2.9%), and other (up 36%).

 

Non-interest Expense

 

Non-interest expense increased $418,000 (12.5%) to $3,749,000 in the second quarter of 2004 versus $3,331,000 in the second quarter of 2003.  On a quarter over quarter basis, full time equivalent employees increased by 8.  Salary and employee benefits increased $156,000 (8%) resulting from normal cost of living raises, commissions paid to Butte Community Bank’s Real Estate Loan agents and staffing additions made during the year as the Company continues to grow and implement the new technology acquired during the year.  Benefit costs and employer taxes increased commensurate with the salaries.    On a quarter over quarter basis, occupancy expenses were higher by $41,000 (20.1%).  This increase in costs is associated with the opening of the Red Bluff office and the Marysville office, and is related to building depreciation, utilities, janitorial services and property taxes.   Fixed asset expense was $311,000 in the second quarter of 2004 compared to $233,000 in the same period of 2003, representing a 33.5% increase.   Other expenses increased $142,000 (14.9%) in the second quarter of 2004 versus the second quarter of 2003.

 

Non-interest expense for the six month period ended June 30, 2004 was $7,536,000 versus $6,551,000 for the same period in 2003.  Salaries and benefits increased by $494,000 (12.7%) due to cost of living raises added benefit costs and employer taxes associated with the staffing additions made during the year as the Company continues to grow and implement the new technology acquired during the year.  On a year over year basis, full time equivalent employees increased by 16 to 189.   Premises expense was up $108,000 (28.7%) from the first six months of 2003 to the first six months of 2004.  Fixed asset expense was up 191,000 (40.4%).  This increase relates to technology upgrades made to our core banking systems and the furniture fixtures and equipment needed to open the two offices mentioned above. As with the quarter-to-quarter comparison, much of the increase in premise expense is also related to the opening of the new Red Bluff and Marysville offices.   Other expenses increased by $388,000 (24%).

 

Provision for Loan Losses

 

The Company provided $190,000 for loan losses for the second quarter of 2004 as compared to $120,000 for the second quarter of 2003.  Net loan recoveries for the three months ended June 30, 2004 was $1,000 as compared to $3,000 in net recoveries for the three months ended June 30, 2003.   For the first six months of 2004, the Company made provisions for loan losses of $415,000.   This compares to the provision for loan losses of $270,000 for the first six months of 2003.

 

Provision for Income Taxes

 

The effective tax rate for the second quarter and first six months of 2004 was 41.3% and 40.6%, versus 43.2% and 41.4%, for the same period in 2003.

 

Balance Sheet Analysis

 

The Company’s total assets were $414,586,000 at June 30, 2003 as compared to $386,723,000 at December 31, 2003, representing an increase of 7.2%.  The average balance of total assets for the six months ended June 30, 2004 was $401,613,000, which represents an increase of $50,041,000 (14.2%) over the $351,572,000 during the six-month period ended June 30, 2003.

 

18

 

Loans

 

The Company concentrates its lending activities in the following principal areas: 1) commercial; 2) real estate; 3) residential real estate and real estate construction (both commercial and residential); 4) agriculture; and 5) consumer loans.  Commercial and residential real estate loans are generally secured by improved property, with original maturities of 3-10 years.  At June 30, 2004, these principal areas accounted for approximately 20%, 43%, 20%, 9% and 8%, respectively, of the Company’s loan portfolio.    The mix at December 31, 2003 was 20%, 42%, 23%, 8% and 8%.  Continuing strong economic activity in the Company’s market area, new borrowers developed through the Company’s marketing efforts and credit extensions expanded to existing borrowers, offset by normal loan pay-downs and payoffs, resulted in net increases in loan balances for commercial loans These changes are consistent with the Company’s history of increased real estate construction activity during the summer months.  Continuing strong economic activity in the Company’s market area, new borrowers developed through the Company’s marketing efforts and credit extensions expanded to existing borrowers, offset by normal loan pay-downs and payoffs, resulted in net increases in loan balances for commercial loans ($7,411,000 or 13.7%), residential real estate ($17,873,000 or 15.6%) agricultural loans ($7,640,000 or 36.7%),and consumer ($1,430,000 or 6.5%) and a decrease in real estate construction ($7,000 or .01%).  Table Five below summarizes the composition of the loan portfolio as of June 30, 2004 and December 31, 2003.

 

Table Five: Loan Portfolio Composition (Unaudited)

 

(In thousands)		June 30, 2004			December 31, 2003
Commercial		$	61,487		$	54,076
Real estate:
Mortgage		132,785			114,912
Construction		63,189			63,196
Agriculture		28,460			20,820
Consumer		23,277			21,847
Total loans		309,198			274,851
Allowance for loan losses		(4,013		)	(3,587		)
Deferred loan fees, net		(1,056		)	(1,033		)
Total net loans		$	304,129		$	270,231

 

The majority of the Company’s loans are direct loans made to individuals and local businesses.  The Company relies substantially on local promotional activity and personal contacts by bank officers, directors and employees to compete with other financial institutions.  The Company makes loans to borrowers whose applications include a sound purpose and a viable primary repayment source, generally supported by a secondary source of repayment.

 

Commercial loans consist of credit lines for operating needs, loans for equipment purchases, working capital, and various other business loan products.  Consumer loans include a range of traditional consumer loan products such as personal lines of credit and loans to finance purchases of autos, boats, recreational vehicles, mobile homes and various other consumer items.  Real estate construction loans are generally composed of commitments to customers within the Company’s service area for construction of both commercial properties and custom and semi-custom single-family residences.  Real estate mortgage loans consist primarily of loans secured by first trust deeds on commercial and residential properties typically with maturities from 3 to 10 years and original loan to value ratios generally from 65% to 80%.  Agriculture loans consist primarily of crop loans to farmers of peaches, prunes, walnuts, and almonds.  In general, except in the case of loans with SBA or FMHA guarantees, the Company does not make long-term mortgage loans; however, Butte Community Bank has a residential lending division to assist customers in securing most forms of longer term single-family mortgage financing.

 

19

 

Risk Elements

 

The Company assesses and manages credit risk on an ongoing basis through a total credit culture that emphasizes excellent credit quality, extensive internal monitoring and established formal lending policies.  Additionally, the Company contracts with an outside loan review consultant to periodically review the existing loan portfolio.  Management believes its ability to identify and assess risk and return characteristics of the Company’s loan portfolio is critical for profitability and growth.  Management strives to continue its emphasis on credit quality in the loan approval process, active credit administration and regular monitoring.  With this in mind, management has designed and implemented a comprehensive loan review and grading system that functions to continually assess the credit risk inherent in the loan portfolio.

 

Ultimately, underlying trends in economic and business cycles may influence credit quality.  The Company’s business is concentrated in the Butte and Sutter County Area. The economy of these two counties is diversified with professional services, manufacturing, agriculture and real estate investment and construction.

 

Special emphasis is placed within the communities in which the Company has offices (Chico, Paradise, Magalia, Oroville, Yuba City, Red Bluff, and Marysville).  The Company also maintains loan production offices in the cities of Citrus Heights and Redding.  Single-family residential construction is the primary lending product from the Roseville location serving the greater Sacramento area.  The primary focus of the loan production office in Redding is commercial loans with an emphasis on SBA and other government loan programs.

 

The Company has significant extensions of credit and commitments to extend credit that are secured by real estate.  The ultimate repayment of these loans is generally dependent on personal or business cash flows or the sale or refinancing of the real estate.  The Company monitors the effects of current and expected market conditions and other factors on the collectability of real estate loans.  The more significant factors management considers involve the following:  lease, absorption and sale rates; real estate values and rates of return; operating expenses; inflation; and sufficiency of collateral independent of the real estate including, in limited instances, personal guarantees.

 

In extending credit and commitments to borrowers, the Company generally requires collateral and/or guarantees as security.  The repayment of such loans is expected to come from cash flow or from proceeds from the sale of selected assets of the borrowers.  The Company’s requirement for collateral and/or guarantees is determined on a case-by-case basis in connection with management’s evaluation of the creditworthiness of the borrower.  Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, income-producing properties, residences and other real property.  The Company secures its collateral by perfecting its security interest in business assets, obtaining deeds of trust, or outright possession among other means.

 

In management’s judgment, a concentration exists in real estate loans, which represented approximately 63.4% of the Company’s loan portfolio at June 30, 2004, which reflects an improvement from the 64.8% concentration level at December 31, 2003.  Management believes the concentration to have no more than the normal risk of collectability; however, a substantial decline in the economy in general, or a decline in real estate values in the Company’s primary market areas in particular, could have an adverse impact on the collectability of these loans and require an increase in the provision for loan losses which could adversely affect the Company’s future prospects, results of operations, profitability and stock price.  Management believes that its lending policies and underwriting standards will tend to minimize losses in an economic downturn; however, there is no assurance that losses will not occur under such circumstances.  The Company’s loan policies and underwriting standards include, but are not limited to, the following: (1) maintaining a thorough understanding of the Company’s service area and originating a significant majority of its loans within that area, (2) maintaining a thorough understanding of borrowers’ knowledge, capacity, and market position in their field of expertise, (3) basing real estate loan approvals not only on market demand for the project, but also on the borrowers’ capacity to support the project financially in the event it does not perform to expectations (whether sale or income performance), and (4) maintaining conforming and prudent loan to value and loan to cost ratios based on independent outside appraisals and ongoing inspection and analysis by the Company’s lending officers.

 

20

 

Nonaccrual, Past Due and Restructured Loans

 

Management generally places loans on nonaccrual status when they become 90 days past due, unless the loan is well secured and in the process of collection.  Loans are charged off when, in the opinion of management, collection appears unlikely.

 

Table Six below sets forth nonaccrual loans as of June 30, 2004 and December 31, 2003.  There were no loans past due 90 days or more and still accruing interest at June 30, 2004 or December 31, 2003.

 

Table Six:  Non-Performing Loans (Unaudited)

 

(In thousands)		June 30, 2004			December 31, 2003
Nonaccrual:
Commercial		47			46
Real estate		71
Consumer and other		7			8
Total non-performing loans		$	125		$	54

 

At June 30, 2004, non-performing loans and leases were .04% of total loans and leases.  The recorded investments in loans that were considered to be impaired totaled $125,000 at June 30, 2004 and $54,000 at December 31, 2003.  One of the four impaired loans shown for June 30, 2004 had a U.S. Government guarantee for 80% of the loan balance which was $22,830.  The remaining balance of this loan is $5,707 and will be charged off.   The other three loans have a very low potential for loss.  There were no loan concentrations in excess of 10% of total loans not otherwise disclosed as a category of loans as of June 30, 2004 or December 31, 2003.  Management is not aware of any potential problem loans, which were accruing and current at June 30, 2004, where serious doubt exists as to the ability of the borrower to comply with the present repayment terms.

 

Allowance for Loan Losses Activity

 

We employ a systematic methodology for determining the allowance for loan losses that includes a monthly review process and monthly adjustment of the allowance.  Our process includes a periodic review of individual loans that have been specifically identified as problem loans or have characteristics which could lead to impairment, as well as detailed reviews of other loans (either individually or in pools).  While this methodology utilizes historical and other objective information, the establishment of the allowance for loan losses and the classification of loans are, to some extent, based on management’s judgment and experience.

 

Our methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan losses that management believes is appropriate at each reporting date.  Quantitative factors include our historical loss experience, delinquency and charge-off trends, collateral values, changes in non-performing loans, and other factors.  Quantitative factors also incorporate known information about individual loans, including borrowers’ sensitivity to interest rate movements and borrowers’ sensitivity to quantifiable external factors including commodity prices as well as acts of nature (freezes, earthquakes, fires, etc.) that occur in a particular period.

 

Qualitative factors include the general economic environment in our markets and, in particular, the state of the agriculture industry and other key industries in the Northern Sacramento Valley.  The way a particular loan might be structured, the extent and nature of waivers of existing loan policies, loan concentrations and the rate of portfolio growth are other qualitative factors that are considered.

 

21

 

Our methodology is, and has been, consistently followed.  However, as we add new products, increase in complexity, and expand our geographic coverage, we expect to enhance our methodology to keep pace with the size and complexity of the loan portfolio.  On an ongoing basis we engage outside firms to independently assess our methodology, and to perform independent credit reviews of our loan portfolio.  The FDIC and the California Department of Financial Institutions review the allowance for loan losses as an integral part of the examination processes.  Management believes that our current methodology is appropriate given our size and level of complexity.  Further, management believes that the allowance for loan losses is adequate as of June 30, 2004 to cover known and inherent risks in the loan portfolio.  However, fluctuations in credit quality, or changes in economic conditions or other factors could cause management to increase or decrease the allowance for loan losses as necessary.

 

The Loan Committee of the Bank reviews the adequacy of the allowance for loan losses at least quarterly to include consideration of the relative risks in the portfolio and current economic conditions.  The allowance is adjusted based on that review if, in the judgment of the loan committee and management, changes are warranted.  The allowance for loan losses totaled $4,013,000 or 1.30% of total loans at June 30, 2004 and $3,587,000 or 1.31% at December 31, 2003.  Net recoveries to average loans for the second quarter were zero and year to date through June 30, 2004 are.004%.

 

Table Seven below summarizes, for the periods indicated, the activity in the allowance for loan losses

 

22

 

Table Seven: Allowance for Loan Losses (Unaudited)

 

		Three Months Ended June 30,						Six Months Ended June 30,
(In thousands, except for percentages)		2004			2003			2004			2003
Average loans outstanding		$	298,616		$	246,939		$	288,741		$	243,065
Allowance for possible loan losses at beginning of period		$	3,822		$	3,154		$	3,587		$	3,007
Loans charged off:
Commercial
Real estate
Consumer					(1		)	(7		)	(4		)
Total					(1		)	(7		)	(4		)
Recoveries of loans previously charged off:
Commercial								14
Real estate
Consumer		1			4			3			4
Total		1			4			17			4
Net loan recoveries		1			3			10
Additions to allowance charged to operating expenses		190			120			415			270
Allowance for loan losses at end of period		$	4,013		$	3,277		4,013			3,277
Ratio of net charge-offs to average loans outstanding		.00		%	.00		%	.00		%	.00		%
Provision for possible loan losses to average loans outstanding		.06		%	.05		%	.14		%	.11		%
Allowance for loan losses to loans net of deferred fees at end of period		1.30		%	1.34		%	1.30		%	1.34		%

 

It is the policy of management to maintain the allowance for loan losses at a level adequate for known and inherent risks in the portfolio.  Based on information currently available to analyze inherent credit risk, including economic factors, overall credit quality, historical delinquencies and a history of actual charge-offs, management believes that the provision for loan losses and the allowance are prudent and adequate.  The Company generally makes monthly allocations to the allowance for loan losses.  The budgeted allocation is based on estimates of loss risk and loan growth.  Adjustments may be made based on differences from estimated loan growth, the types of loans constituting this growth, changes in risk ratings within the portfolio, and general economic conditions.  However, no prediction of the ultimate level of loans charged off in future years can be made with any certainty.

 

Other Real Estate

 

At June 30, 2004 and December 31, 2003, the Company did not have any other real estate (“ORE”) properties.

 

23

 

Deposits

 

At June 30, 2004, total deposits were $367,632,000 representing an increase of $25,121,000 (7.3%) over the December 31, 2003 balance of $342,511,000.

 

Capital Resources

 

The current and projected capital position of the Company and the impact of capital plans and long-term strategies are reviewed regularly by management. The Company’s capital position represents the level of capital available to support continued operations and expansion.

 

The Board of Directors of the Company authorized the payment of a cash dividend of $.056 per share on January 23, 2003, April 24, 2003, July 25, 2003, October 24, 2003, and $.075 per share on January 23, 2004, March 23, 2004, and June 15, 2004.  The payment of dividends in the future is subject to the discretion of the Board of Directors of the Company and will depend on earnings, the financial condition of the Company and other relevant factors.  The per share amounts have been retroactively restated for the Company’s 4 for 3 stock split approved by the Board of Directors on February 17, 2004.

 

The Company and its subsidiary Bank are subject to certain regulations issued by the Board of Governors of the Federal Reserve System and the FDIC which require maintenance of certain levels of capital.  At June 30, 2004, shareholders’ equity was $32,115,000, representing an increase of $2,166,000 (7.2%) from $29,949,000 at December 31, 2003.  The Bank’s ratio of total risk-based capital to risk adjusted assets was 11.3% at June 30, 2004 compared to 12.1% at December 31, 2003.  Tier 1 risk-based capital to risk-adjusted assets was 10.1% at June 30, 2004 and 10.9% at December 31, 2003.

 

Table Eight below lists the Company and the Bank capital ratios at June 30, 2004 and December 31, 2003, as well as the minimum ratios required under regulatory definitions of capital adequacy.

 

Table Eight:  Capital Ratios (Unaudited)

 

Capital to Risk-Adjusted Assets		At June 30, 2004		At December 31, 2003		Minimum Regulatory Requirement
Company
Leverage ratio		9.8	%	9.9	%	4.0	%
Tier 1 Risk-Based Capital		10.4	%	12.2	%	4.0	%
Total Risk-Based Capital		12.6	%	13.4	%	8.0	%
Bank
Leverage ratio		9.0	%	8.8	%	4.0	%
Tier 1 Risk-Based Capital		10.1	%	10.9	%	4.0	%
Total Risk-Based Capital		11.3	%	12.1	%	8.0	%

 

Capital ratios are reviewed on a regular basis to ensure that capital exceeds the prescribed regulatory minimums and is adequate to meet future needs.  All ratios are in excess of the regulatory definition of “Minimum” at June 30, 2004 and December 31, 2003.  The Bank was considered “well-capitalized” by regulatory standards, at June 30, 2004 and December 31, 2003.

 

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Item 3.  Quantitative and Qualitative Disclosures about Market Risk

 

Market Risk Management

 

Overview.  Market risk is the risk of loss from adverse changes in market prices and rates.  The Company’s market risk arises primarily from interest rate risk inherent in its loan, investment and deposit portfolios.  The goal for managing the assets and liabilities of the Company is to maximize shareholder value and earnings while maintaining a high quality balance sheet without exposing the Company to undue interest rate risk.

 

The Board of Directors has overall responsibility for the interest rate risk management policies.  The Bank has an Asset and Liability Management Committee (ALCO) that establishes and monitors guidelines to control the sensitivity of earnings to changes in interest rates.

 

Asset/Liability Management.  Activities involved in asset/liability management include, but are not limited to, lending, accepting and placing deposits, investing in securities, using trust preferred securities and borrowings.  Interest rate risk is the primary market risk associated with asset/liability management.  Sensitivity of earnings to interest rate changes arises when yields on assets change in a different time period or in a different amount from that of interest costs on liabilities.  To mitigate interest rate risk, the structure of the balance sheet is managed with the goal that movements of interest rates on assets and liabilities are correlated and contributes to earnings even in periods of volatile interest rates.  The asset/liability management policy sets limits on the acceptable amount of variance in net interest margin and market value of equity under changing interest environments.  The Company uses simulation models to forecast earnings, net interest margin and market value of equity.

 

Simulation of earnings is the primary tool used to measure the sensitivity of earnings to interest rate changes.  Using computer-modeling techniques, the Company is able to estimate the potential impact of changing interest rates on earnings.  A balance sheet forecast is prepared monthly using inputs of actual loans, securities and interest bearing liability (i.e. deposits/borrowings) positions as the beginning base.  The forecast balance sheet is processed against seven interest rate scenarios.  These scenarios include a 100, 200 and 300 basis point rising rate forecast, a flat rate forecast and a 100, 200 and 300 basis point falling rate forecast which take place within a one year time frame.  The net interest income is measured during the year assuming a gradual change in rates over the twelve-month horizon.  The Company’s net interest income, as forecast below, was modeled utilizing a forecast balance sheet projected from balances as of the date indicated.

 

Table Nine below summarizes the effect on net interest income (NII) of a ±200 basis point change in interest rates as measured against a constant rate (no change) scenario.  The results shown in Table nine for the two periods, fall within the parameters of the Bank’s policy for interest rate risk.

 

Table Nine:  Interest Rate Risk Simulation of Net Interest as of June 30, 2004 and December 31, 2003 (Unaudited)

 

(In thousands)		$ Change in NII from Current 12 Month Horizon June 30, 2004			$ Change in NII from Current 12 Month Horizon December 31, 2003
Variation from a constant rate scenario
+200bp		$	487		$	286
- 200bp		$	461		$	714

 

The simulations of earnings do not incorporate any management actions which might moderate the negative consequences of interest rate deviations.  Therefore, they do not reflect likely actual results, but serve as estimates of interest rate risk.  In this simulation, the exposure to net interest income has increased due to a larger volume of assets maturing than liabilities and re-pricing at lower rates.

 

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Inflation

 

The impact of inflation on a financial institution differs significantly from that exerted on manufacturing, or other commercial concerns, primarily because its assets and liabilities are largely monetary.  In general, inflation primarily affects the Company and it subsidiaries through its effect on market rates of interest, which affects the Company’s ability to attract loan customers.  Inflation affects the growth of total assets by increasing the level of loan demand, and potentially adversely affects capital adequacy because loan growth in inflationary periods can increase at rates higher than the rate that capital grows through retention of earnings, which may be generated in the future.  In addition to its effects on interest rates, inflation increases overall operating expenses.  Inflation has not had a material effect upon the results of operations of the Company and its subsidiaries during the periods ended June 30, 2004, and 2003.

 

Liquidity

 

Liquidity management refers to the Company’s ability to provide funds on an ongoing basis to meet fluctuations in deposit levels as well as the credit needs and requirements of its clients.  Both assets and liabilities contribute to the Company’s liquidity position.  Federal funds lines, short-term investments and securities, and loan repayments contribute to liquidity, along with deposit increases, while loan funding and deposit withdrawals decrease liquidity.  The Company assesses the likelihood of projected funding requirements by reviewing historical funding patterns, current and forecasted economic conditions and individual client funding needs.  Commitments to fund loans at June 30, 2004 and December 31, 2003 were approximately $156,872,000 and $141,308,000, respectively.  Such loans relate primarily to revolving lines of credit and other commercial loans, and to real estate construction loans.

 

The Company’s sources of liquidity consist of cash and due from correspondent banks, overnight funds sold to correspondent banks, unpledged marketable investments and loans held for sale.  On June 30, 2004, consolidated liquid assets totaled $74.9 million or 18.1% of total assets compared to $80.1 million or 20.7% of total assets on December 31, 2003.  In addition to liquid assets, the Company maintains short-term lines of credit in the amount of $6,000,000 with correspondent banks.  There were no borrowings outstanding under these arrangements at June 30, 2004.    The Bank also has informal agreements with various other banks to sell participations in loans, if necessary.  The Company serves primarily a business and professional customer base and, as such, its deposit base is susceptible to economic fluctuations.  Accordingly, management strives to maintain a balanced position of liquid assets to volatile and cyclical deposits.

 

Liquidity is also affected by portfolio maturities and the effect of interest rate fluctuations on the marketability of both assets and liabilities.  The Company can sell any of its unpledged securities held in the available-for-sale category to meet liquidity needs.

 

Off-Balance Sheet Items

 

The Company has certain ongoing commitments under operating leases.  These commitments do not significantly impact operating results. As of June 30, 2004 and December 31, 2003, commitments to extend credit and letters of credit were the only financial instruments with off-balance sheet risk.  The Company has not entered into any contracts for financial derivative instruments such as futures, swaps, options or similar instruments.  Loan commitments and letters of credit were $156,872,000 and $141,308,000 at June 30, 2004 and December 31, 2003, respectively.  As a percentage of net loans, these off-balance sheet items represent 49.7% and 52.3%, respectively.

 

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Other Matters

 

Effects of Terrorism The terrorist actions on September 11, 2001 and thereafter have had significant adverse effects upon the United States economy.  Whether the terrorist activities in the future and the actions of the United States and its allies in combating terrorism on a worldwide basis will adversely impact the Company and the extent of such impact is uncertain.  However, such events have had and may continue to have an adverse effect on the economy in the Company’s market areas.  Such continued economic deterioration could adversely affect the Company’s future results of operations by, among other matters, reducing the demand for loans and other products and services offered by the Company, increasing nonperforming loans and the amounts reserved for loan losses, and causing a decline in the Company’s stock price.

 

Item 4. Controls and Procedures

 

(a) Disclosure Controls and Procedures: An evaluation of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) was carried out under the supervision and with the participation of the Company’s Chief Executive Officer, Chief Financial Officer and other members of the Company’s senior management as of the end of the Company’s fiscal quarter ended March 31, 2004. The Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures as currently in effect are effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is (i) accumulated and communicated to the Company’s management (including the Chief Executive Officer and Chief Financial Officer) to allow timely decisions regarding required disclosure, and (ii) recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms.

 

(b) Internal Control Over Financial Reporting: An evaluation of any changes in the Company’s internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)), that occurred during the Company’s fiscal quarter ended June 30, 2004, was carried out under the supervision and with the participation of the Company’s Chief Executive Officer, Chief Financial Officer and other members of the Company’s senior management. The Company’s Chief Executive Officer and Chief Financial Officer concluded that no change identified in connection with such evaluation has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

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PART II – OTHER INFORMATION

 

Item 1.  Legal Proceedings.

 

None.

 

Item 2.  Changes in Securities and Use of Proceeds.

 

The Board of Directors approved a plan at their June 2003 meeting to repurchase up to $3,000,000 of the outstanding common stock of the Company.  The plan states that stock repurchases may be made from time to time on the open market or through privately negotiated transactions.  The timing of purchases and the exact number of shares to be purchased depends on market conditions.  The share repurchase plan does not include specific price targets or timetables and may be suspended at any time.

 

ISSUER PURCHASES OF EQUITY SECURITIES

 

Period		(a) Total Number of Shares purchased		(b)  Average Price Paid per Share			(c) Total Number of Shares Purchased as Part of Publicly Announced Plan		(d)  Maximum Dollar Value of Shares that May Yet Be Purchased Under the Plan
Month #3 June 1, 2004 to June 30, 2004		12,000		$	26.92		12,000		$	2,676,093

 

Item 3.  Defaults Upon Senior Securities.

 

None.

 

Item 4.  Submission of Matters to a Vote of Security Holders.

 

At the Annual Meeting of Shareholders held on May 29, 2004, one matter came before the meeting for vote:  Election of Directors to serve until the 2004 Annual Meeting or until their successors are elected.  Shares voted by proxy totaled 2,468,861 with no votes withholding authority.

 

Item 5.  Other Information.

 

None

 

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Item 6.  Exhibits

 

(a)  Exhibits

 

Exhibit

 

Number		Document Description
(31.1)		Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
(31.2)		Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
(32.1)		Certification of CEO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
(32.2)		Certification of CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

(b)  Reports on Form 8-K

 

On April 14, 2004 the Company filed a Report on Form 8-k announcing first quarter earnings for 2004.

 

On June 18, 2004 the Company filed a Report on form 8-k announcing a seven and one half cent per share Cash Dividend for shareholders of record on June 30, 2004 payable July 23, 2004.

 

 

SIGNATURES

 

Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

			COMMUNITY VALLEY BANCORP
	August 10, 2004		By:		/s/ Keith C. Robbins
			Keith C. Robbins
			President, Chief Executive Officer
	August 10, 2004		By:	/s/ John F. Coger
			John F. Coger
			Executive Vice President, CFO

 

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